The budget is Darling’s last chance to convince voters and markets

MORE than one budget is expected this year, and there is a good chance that tomorrow’s will be superseded by another once the election has been fought and won. But that doesn’t detract from the fact that there is still an awful lot riding on chancellor Alistair Darling’s words this week.

Firstly, the budget provides the government with a make-or-break opportunity to set out its stall to the electorate ahead of the general election. Opinion polls continue to point to a hung parliament but there is a chance Labour could remain in power in a coalition with the Liberal Democrats – although tomorrow is likely to be Darling’s last budget as chancellor.

Second, Darling must try to achieve voter support while also managing to convince both the credit rating agencies and the financial markets that the budget deficit will be cut drastically over the medium term. The market would certainly favour a government which leapt head first into a programme of spending cuts.

But Labour could still outline an austerity plan for the medium term without necessarily contradicting its stance that too much austerity too soon would endanger the recovery. Either way, the market is demanding firmer detail tomorrow on exactly how the government intends to meet its pledge of halving the huge budget deficit within four years.

The release of better-than-expected public finances data for February will have put a spring back in Darling’s step. With just one month to go until the end of the fiscal year, they suggest that he will be able to announce that public sector borrowing this year is likely to be between £5-£10bn less than the forecast £177.6bn.

In essence this is good news, but it requires qualification. The February numbers may be better than expected but they are a far cry from good data. In the fiscal year to February, net borrowing hit £131.9bn – compared to £66.5bn at the same stage last year – meaning that public finances are still in a shocking condition. In recent days the government has been keen to stress that it won’t use the improvement to announce some pre-election sweeteners. The huge UK fiscal deficit (around 12.9 per cent of GDP) is already a nasty thorn in the side of sterling and extra spending would not be welcomed by investors.

As budget deficits and debt levels are generally measured as ratios to GDP, the chancellor’s forecasts for growth are a crucial element of the budget. It is very likely that the necessary dose of austerity will weigh on growth at least over the next couple of years. The Bloomberg survey of market economists points to growth at a moderate 2.05 per cent in 2011. A downward revision to the government’s 2011 growth projection of 2.50 per cent would protect the chancellor’s credibility even though it would need to be balanced with more austerity measures to achieve the aim of having the budget deficit/GDP ratio in four years.

Last May, ratings agency Standard & Poor’s warned that it had revised the UK’s debt rating outlook to negative from stable. This threat has been largely shrugged off by the government as unrealistic. However, a failure in this week’s budget to map out a credible plan to tackle the deficit would bring a rating downgrade closer. This would inevitably push up gilt yields, raise the cost of funding the deficit and weaken the position of the pound.

Recent weeks have been volatile for sterling. Weakness in cable is correlated with the fear that the general election (expected on 6 May) will provide a hung parliament. The optimal outcome from the election, at least as far as the markets are concerned, would be a clear majority for the Conservative party because a quicker resolution to the deficit is seen as more likely.

But if we assume that a hung parliament is largely priced in and there is a chance that a Labour/Lib Dem alliance could be leading the country for the next five years, reassuring words on deficit reduction tomorrow could bring some near-term support for the pound. That said, in the absence of clear evidence that the government is committed to tackling the budget deficit, cable could still shift significantly lower.

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Overall, the technical outlook for sterling continues to point lower. However, sterling has likely entered a fourth wave consolidation phase and may see a choppy, counter-trend correction higher over the next several weeks. Wave three finished at nearly exactly 1.618 times the distance of wave one, highlighting the preferred wave count. Also limiting the near-term downside, cable has held the long-term trend line support from early 2009, which is currently at $1.4900 and rising. A daily close below there would suggest the correction is over. Prices will be adjusting directly lower and target the $1.4300-$1.4500 area initially. For the potential rebound, sterling-US dollar should not see beyond the 13 October low of $1.5709 if the down move is to continue. Intervening resistance comes in at 1.5300 from the Ichimoku Kijun line.
Brian Dolan, chief currency strategist, Gain